May 11, 2010

Abacus Deal: As Bad as They Come

Abacus 2007-AC1, the mortgage deal at the center of Friday’s civil-fraud lawsuit against Goldman Sachs Group Inc., also boasts another dubious distinction: It was one of the worst-performing mortgage deals of the housing crisis, based on one measure of rating-firm downgrades.
WSJ Professional

Less than a year after the deal was completed, 100% of the bonds selected for Abacus had been downgraded, according to a February 2008 report by Wachovia Capital Markets, since acquired by Wells Fargo & Co.

That was a fate that only two other such deals, known as collateralized debt obligations, or CDOs, suffered around that time, out of hundreds in the Wachovia report. But other mortgage CDOs were also showing signs of distress at the time. And most soon saw their value plunge, as ratings agencies lowered their views on bonds backed by subprime mortgages.

The news about Abacus, whose assets allegedly were chosen with a help of a bearish hedge fund, once again highlights the ratings agencies’ flubs on mortgage-backed bonds that many experts say were a leading cause of the credit crisis.
[RATINGS]

Both Moody’s Investors Service and Standard & Poor’s Ratings Service placed their once-revered triple-A ratings on the Abacus deal. Since Friday, shares of Moody’s Corp. and S&P’s parent McGraw-Hill Cos. have taken a hit, in part on the belief the Goldman case, a civil suit brought by the Securities and Exchange Commission, will raise anew questions about the ability of rating firms to accurately measure the risk in bonds, analysts said. Goldman denies it did anything wrong and is fighting the charges.

A Moody’s spokesman declined to comment. An S&P spokesman had no immediate comment.

The Senate Permanent Subcommittee on Investigations said Monday it would hold hearings Friday about the rating firms’ role in the financial crisis. The hearings, planned before the lawsuit was filed, come as Congress, the SEC and regulators globally are working on passing new rules to try to improve the ratings system.

Their solutions include removing ratings’ role in regulations in an effort to get investors to do their own research and pushing bond raters to disclose more about their processes. Another effort: making it easier for upstart rating firms paid by investors to compete against S&P, Moody’s and other large rating firms, which are paid by bond issuers to rate each bond.Positive ratings were common at the time, helping the Paulson firm place its bets, according to the SEC complaint.

In January 2007, a Paulson employee explained the company’s view, saying that “rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while ‘real money’ investors have neither the analytical tools nor the institutional framework to take action,” according to the complaint.

Mr. Chen, the former Moody’s analyst, called the Abacus deal a “rating arbitrage” trade. In other words, despite the triple A rating, eventually the true, lower value of the bonds would be revealed.